Japanese markets shiver as China slows

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London - Japan's financial markets face a challenging new fiscal year as economic slowdown in its emerging trading partners and a sales tax hike at home push risk-shy investors into cash-like assets.

Almost a year after Japan unleashed the world's most intensive burst of monetary stimulus, the benchmark Nikkei index stands at the bottom of the 2014 performance league, falling 7 percent to be the biggest losing asset after copper.

Portfolio flows also point to investors shedding risk.

Foreign investors, who dominate more than two thirds of daily liquidity, sold a net 191.0 billion yen ($1.87 billion) of shares in the latest week, after selling a record 1.1 trillion yen the week before.

Domestic investors have also been selling their foreign equity and bond investments and bringing the money back home, especially before the fiscal year ends on March 31.

A dramatic mood change towards Japan goes beyond natural underperformance after a bumper 2013, when stocks rose more than 30 percent.

The biggest drag is a slowdown in China, Japan's main trading partner, which hurts Japan Inc's profitability.

Moreover, emerging market volatility and geopolitical risks, along with the yen's rise, have prompted foreign and domestic investors to sell Japanese stocks, spurred by next week's tax hike.

“Japan is starting to suffer from emerging market fallout. The second quarter is a real test for the Chinese and Japanese economies,” said Mike Howell, managing director of CrossBorder Capital.

CrossBorder's index of aggregate liquidity - flow of cash and credit - in the private sector dropped to 52.5 at end-February, a decline of 36 percent from a May peak.

“The corporate sector is having a hiccup in terms of its cash generation, either because sales are weak or costs are higher,” Howell said.

He estimated around half of foreign portfolio flows goes into currency-neutral futures, while the rest goes into yen-denominated exchange-traded funds or physical shares.

“If you buy ETFs or the yen-denominated Nikkei, clearly you have currency risks. If there's no recovery in private sector cash flow, we're unlikely to see a strong rebound in stock markets unless the BOJ eases further or the yen devalues.”

Japan's deteriorating current account position also confirms weak exports and reduced private sector cash flows.

The current account logged a record deficit in January as a weak yen and consumption before the tax hike drove up imports, already elevated by demand for fossil fuel to make up for nuclear energy lost since the 2011 Fukushima disaster.

 

REBALANCING

It's not just foreign investors who are risk-averse.

The BOJ's quantitative and qualitative easing (QQE) has yet to have its intended impact of driving Japanese investors out of low-risk Japanese government bonds.

Daiwa Capital Markets cites the BOJ's data showing insurance firms and pension funds remained net buyers of JGBs in the fourth quarter, leaving JGBs as the largest share of their financial assets at 45 percent and 24 percent respectively.

“There remains little evidence of the major portfolio rebalancing that ought to happen if and when Japanese investors truly believe that QQE is shifting Japan's economy back on to the path of sustainable growth and inflation,” Daiwa said.

Japanese corporates are also holding near record amounts of cash on their balance sheets.

They currently have around $942 billion of cash and equivalents, up 32 percent from end-2008 levels, according to Thomson Reuters data.

According to a poll by Bank of America Merrill Lynch, fund managers are a net 16 percent overweight on Japanese stocks, a 12-month low, and they think short yen is the most crowded trade in global markets.

Around one in three investors polled by Barclays Capital said the macro trade in Japan had largely run its course, while they still liked long equity and short yen positions.

“There appears to be increasing market doubt over the sustainability of the Japan trade,” Barclays said in a note.

It said the next stage will include less emphasis on short yen but potential outperformance of small cap domestic equities and strategic short JGBs.

“Over the longer term, we can expect less dependence on foreign flows as domestic investors gradually shift asset allocation in favour of equities if the economy continues to reflate,” it said. - Reuters



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